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Fannie, Freddie Fix Is a Federal Hot Potato

By

Nick Timiraos

Updated May 24, 2010 12:01 a.m. ET

Fannie Mae and Freddie Mac, the mortgage-finance giants that are now wards of the government, are on their way to becoming the single-biggest cost to taxpayers from the financial crisis—ahead of the banks, auto makers, or even insurer American International Group.

But while Washington is on the cusp of enacting a broad revamp of the financial regulatory infrastructure, it's in no hurry to touch Fannie and Freddie.

"The administration has put it on the 'too hard' pile," says David Felt, a former senior lawyer at the companies' federal regulator who presided over the government takeover of the companies in 2008.

Former Fannie executives Robert Levin, left, and CEO Daniel Mudd testify at a government hearing in April.
Bloomberg News

Among the reasons for the hands-off approach: Freddie and Fannie are playing a bigger role in the housing market today than before the bust; the Obama administration says it's reluctant to address the firms' future until markets are more stable. Together with the Federal Housing Administration, Fannie and Freddie guaranteed 96.5% of all new home loans last quarter. Officials fear hasty action could send a recovery into reverse.

Republicans, meanwhile, introduced a measure during the financial-overhaul debate that detailed how to wind down the companies, but the amendment, which was defeated, didn't specify what would take their place.

Fannie and Freddie don't make loans directly to consumers; instead, they buy loans from banks and sell them to investors as securities. Investors long assumed that the government would stand behind Fannie and Freddie, and the lower funding costs from that implied guarantee enabled banks to subsidize the costs of pre-payable, 30-year fixed-rate loans.

For years, the companies managed the conflicts of providing shareholder returns while fulfilling a public mission. But that model unraveled during the housing boom as the firms stuffed their portfolios with risky mortgage securities from Wall Street banks and later loosened their own loan standards. As defaults mounted, the government took the companies and agreed to inject capital to keep them afloat.

That tab has swelled to $145 billion so far and figures to grow as foreclosures continue to pile up.

The losses being reported today are a legacy of mistakes made during the boom, not from current activities. It's unrealistic to suggest that the government can walk away from those losses or limit the amount taxpayers will cover unless it's willing to sacrifice confidence in U.S. investments. The loans that Freddie and Fannie are making today have much tougher underwriting standards and are expected to be profitable for the companies.

Chief among the problems Congress is hesitant to confront: Fannie and Freddie offered a convenient off-budget means of subsidizing housing that continues today with the companies under government control. If lawmakers are truly serious about ending the model, they will either have to give up those subsidies, fund them more explicitly by, for example, paying for them up front in the annual budget, or find a new way to disguise them.

Swagel-Marron Proposal on Fannie, Freddie Overhaul

Among the weighty questions awaiting policy makers: Should the government continue to promote long-term, fixed-rate loans?

Higher employment volatility and divorce rates have contributed to a "rate of homeownership that is more volatile," and less compatible with long-term mortgages, says Raj Date, executive director of the Cambridge Winter Center for Financial Institutions Policy, a think tank that researches financial-institution policy. Moving to a fully private market would raise housing costs, he says, but it would better protect taxpayers.

But that approach would likely be unpopular. Americans have come to regard fixed-rate loans "as part of their civil rights," says Susan Woodward, a former chief economist for the Department of Housing and Urban Development and the Securities and Exchange Commission. It would not only limit homeownership, she says, but would also transfer risks to the biggest banks, which would grow more dominantstill in the market.

Phillip Swagel, a former assistant Treasury secretary under President George W. Bush, says it is inevitable that the government will end up playing some role in backstopping mortgages. Instead of debating whether the government should be involved at all, policymakers should focus on clearly spelling out public and private roles, he says.

In a forthcoming proposal with former Bush administration economist Donald Marron, Mr. Swagel suggests converting Fannie and Freddie into private firms that securitize mortgages that meet specific standards. They would purchase, for a fee, insurance with explicit government backing. To foster competition, other financial firms could ultimately join Fannie and Freddie in securitizing loans and buying the government guarantee.

Mr. Swagel says the companies should jettison less-transparentbusiness activities, such as affordable-housing initiatives that could instead be funded through appropriations to federal and state housing agencies. A working group convened by the Center for American Progress, a liberal think tank, proposes charging a fee on new mortgage-backed securities to fund such efforts.

A host of other questions await lawmakers: Should any successors to Fannie and Freddie support affordable and multifamily housing, and if so, how? Should they keep a portfolio to serve as a buyer of last resort during crises?

Ultimately, to fix Fannie and Freddie, Congress will have to be honest about what it wants. Talk about "abolishing" Fannie and Freddie is easy, but it may prove harder to give up many of the hidden benefits the companies continue to offer.

Fannie, Freddie Fix Is a Federal Hot Potato

Fannie Mae and Freddie Mac, the mortgage-finance giants that are now wards of the government, are on their way to becoming the single-biggest cost to taxpayers from the financial crisis—ahead of the banks, auto makers, or even insurer American International Group.